Inverted Yield Curve


By: Robert & Roy Sokolowski

The news has been awash the past few days with scary headlines about the inverted yield curve. A yield curve is a graphical representation showing the yield (the expected return) an investor gets by purchasing bonds that mature at different dates in the future. Under most normal circumstances, investors who purchase bonds that mature further into the future receive a higher return than those who purchase bonds that mature quickly. This makes sense intuitively- if you loaned money to a friend would you rather have the money back tomorrow or in a year? If it was a year, wouldn’t you expect a higher return to cover your risk?

Investors frequently look at the treasury (U.S. government debt) yield curve because the rates on U.S. government debt underpin a lot of the theory and many of the models used to value everything from stocks to corporate bonds to options. For the rest of the population, the typically minute changes in the shape and level of the yield curve are of little consequence. Sure, a drop in interest rates might allow you to refinance your mortgage and save on your monthly payment, but for most people that is about the extent of the impact. So why was there so much commotion regarding this arcane chart this week?

The media and the markets reacted the way they did because the yield on the 10-year treasury fell below the yield on the 2-year treasury on Monday for the first time since December 2005, before the great recession. The so-called “2-10” spread or the yield on the 10-year treasury minus the yield on the 2-year treasury is used as a “warning signal” by economists to predict a recession. The 2-10 spread has “predicted” seven of the last nine recessions, but each of the past five.

So, the 2-10 spread would seem to be a very reliable recession warning. The trouble, as is the case with all predictions, is determining when that recession is going to occur. The last 2-10 inversion preceded the great recession, but the recession didn’t occur for some two years after the initial inversion. As CNBC.com notes, a Credit Suisse study found that the average recession doesn’t start for another 22 months following a 2-10 inversion and the S&P 500 is up some 12% in one year following an inversion. Compare this to the average return for the S&P 500 since 1957 of 7.96%, and you’ll see that post inversion years are some of the stock market’s strongest.

The chart below shows the difference in the yield curve between yesterday, 1 month ago and 1 year ago. As you can see, we have gone from a normal shaped curve a year ago, to a “kinked” one a month ago, to a lower and kinked one on Wednesday. It should be noted that the curve is not truly inverted at this point as the 30-year rates are still higher than the short-term debt. It is only a portion of the curve that is inverted. Furthermore, the curve shows little difference in shape since a month ago. The most noteworthy aspect to me is the significant lowering of the curve over the past month.

The chart below shows the collapse of the 2-10 spread over the past 3 years. Note that this spread has been falling since late 2016- the inevitable inversion (a spread below zero) should have come as a shock to no one.

Below is another graphical representation of treasury yields. As you can see, the longer-term trend in rates is that they have been falling. Note however, that portions of the yield curve have been inverted since December 2018- just not the “benchmark” 2-10 spread.

The good news for investors holding bonds is that this drop in yields means that the value of bonds has been rising. The following chart shows the returns of the Vanguard Total Bond Market ETF which tracks the performance of the total US investment grade bond market:

As you can see, the value of the bonds has increased 7.14% in the past year, with the interest payments adding another 3.14% return. This is a very large move and total return for the normally sluggish bond market. The vast majority of our clients have some portion of their portfolio allocated to bonds and have seen the value of those bonds increase as yields have fallen.

I’ve been looking at this chart over the past few days as the market has been volatile. It shows the percent the S&P 500 is below its all-time high. Zero percent indicates the market is at an all-time high.

As you can see, we recently set an all time high and as of the close of the market on 8/14/19, the S&P 500 was only 5.89% below the all time high. Clearly, a 5% pullback happens quite frequently and the past couple years have seen fewer 5% pullbacks than normal. You can also see that the stock market spends most of it’s time below the all time high. This is one of the most counterintuitive aspects of investing- markets tend to go up over time, yet spend relatively little time at an all-time high.

So, what should we make of the most recent “yield curve inversion?” While it’s true that the 2-10 spread is a relatively reliable recession indicator, it doesn’t bat 1,000. Even if we knew that this 2-10 inversion was accurately predicting recession, we wouldn’t know when recession would occur. Finally, we know that stock market returns have historically been some of the strongest in the year following a 2-10 inversion.

What do we think will happen next? While there are some warning signs of a global slowdown, we do not see an indication of recession in the short-term. In fact, the economic data in the U.S. has been a mix of some data that is quite good such as employment with some more middling data like capital expenditures. The past several weeks have seen rising geopolitical risks (see Hong Kong, Kashmir, Argentina, and the trade war with China) that have caused us to get less bullish on foreign equities. Over the past several months we have been making several adjustments to client portfolios (as appropriate) that we believe best position us for what’s ahead:

  • We aggressively bought treasuries last year while they were yielding over or close 3%. These yields are locked in and the prices of those bonds has risen as the market yields have fallen.
  • We have maintained a large exposure to high quality utility companies with a strong dividend. Utilities are often called “bond proxies” and tend to rise in price as interest rates fall.
  • We have selectively reduced or eliminated our foreign stock exposure where appropriate.
  • We have focused on buying high quality companies with a focus on growth and/or dividend yield.

Over the past week we have reviewed all our clients’ portfolios and we feel good about the companies and the bonds we hold. We will continue to monitor the markets as always and make the adjustments we feel prudent.

As always, don’t hesitate to contact us at any time if you have questions or concerns.